2012 Outlook

In
many respects, I think it would be productive for us and our investors
to pull a Rip Van Winkle next year. My confidence in our outlook is
pretty high, but I think we are likely to endure an unpredictable
journey to get there. Falling asleep for 12 months would probably be
easier, but that would result in missing all the "fun"!

Economy

Leading
economic indicators from Economic Cycle Research Institute suggest that
much of Europe is already in or entering recession, and that Germany
and France are at risk of heading in that direction. The US is likely
already in recession or will be in the near term. Emerging markets like
China, India and Brazil are experiencing classic cyclical business cycle
dynamics, as higher inflation rates drove tighter monetary policy,
which resulted in inverted bond market yield curves, and now their
economies are poised to slow significantly. Even Australia, which has
gone without an official recession for 20 years, appears to be heading
in that direction. It is possible that a global recession unfolds.

Of
course, just forecasting a "recession" isn't being very specific,
though very few firms are neither willing to stick their necks out to
forecast any kind of recession, nor look at depth and duration. It is
that latter question that we believe is a critical nuance as we look
towards 2012. Not every recession has to be a horrific contraction like
we faced in 2008. In fact, history shows that about 25% of recessions
have been relatively short and shallow, 50% have been "normal", and
about 25% have been sharp and prolonged - and often accompanied by a
major financial crisis. If our expectation that policy makers across the
globe will continue to respond to the economic weakness on a more
proactive basis than we experienced in 2008, then we believe the risks
of a deeper and more prolonged recession are low. However, the economy's
weakness does make it more vulnerable to shocks, whether it is war with
Iran that results in $200 oil or any other kind of shock one can
imagine.

Financial Markets

At
this point we believe that financial markets already discounted a
shallow or normal recession with its significant declines in 2011. Large
and mega cap US indexes were very resilient relative to smaller and mid
cap stocks, as well as most international markets. From peak to trough,
most global markets were down between 30%-40%, while US small and mid
cap stocks were down about 30% and 28% respectively, from peak to
trough. Economically sensitive sectors in the US like industrials,
materials, and energy were down 28%, 32% and 33% from peak to trough.

Mega
cap high quality US stocks, which in aggregate had been horrible for
10+ years, finally enjoyed a period of significant out performance. This
is reflected in the fact that the Dow Jones Industrial Average was down
about 19% peak to trough. However, that decline was due largely to
financial and industrial stocks. Blue chip stocks like Johnson and
Johnson (JNJ), Proctor and Gamble (PG), and IBM (IBM) were flat or even
up during the period. Those stocks entered the year at very reasonable
or even absolutely cheap valuation levels, so it makes sense that they
could be more resilient during a bear market. In addition, their
business profiles tend to be more defensive and hold up better during
economic weakness - hence the label "high quality".

Industrial
commodities also suffered significant declines from peak to trough:
copper was down about 35%, WTI crude oil down about 34%, nickel was down
42%, and lead was down 40%. "Hard currencies" like the Australian and
New Zealand dollars were down 15% and 16%, while emerging market
currencies like the Brazilian real and Mexican peso were down 27% and
19% versus the US dollar.

While these were not declines as
severe as we witnessed in 2008, collectively they are what I would call
being at "mini-2008" levels. As I've expressed over the past 6+ months
in this blog, it would be historically weird for two crises to unfold in
identical or even very similar fashions so closely together. I believe
this is very logical, as a crisis so traumatic and severe as we
experienced in 2008 will only naturally extend a very long shadow. For
example, many of those who lived through the crash of 1929 and Great
Depression were terribly, and logically, impacted by that experience and
forever worried about the next crash or depression. More recently, many
in the US called for a Monday crash nearly every time a weak Friday
unfolded following the 1987 crash and its long shadow. I still read
commentary from people who lived through that period who are still
obviously impacted by the legacy.

I believe this back drop
supports our thesis that a normal cyclical decline has already occurred
in financial markets in anticipation of recession. An examination of
history shows many examples where financial markets "bottom" at the very
beginning of, or even before, a recession. That is precisely what we
believe is likely to have occurred this cycle, though we recognize that
substantial shocks to the economy could change this outlook.

Long
term valuation metrics for the US stock market are back to what I would
call "blah". Most stock market segments are not cheap on an absolute
basis, but very cheap relative to bonds. This is also the case in many
global markets, though some in Europe and emerging market countries have
returned to absolutely cheap levels. We are in no way deviating from
our long term outlook that the US stock market remains in a secular bear
market. Our main deviation from consensus is that we've already
experienced another cyclical bear market and are in the midst of the
next cyclical bull market.

Bonds, Currencies and Governments

It
is difficult to discuss any outlook for bond and currency markets
without discussing politics and governments. With the massive debt
problems in the euro zone, UK, US and Japan, we believe massive
government intervention in bond and currency markets is here to stay for
some time. Whether it is price fixing interest rates, money printing,
capital controls or trade wars, we expect the political environment to
get increasingly more volatile. We believe the US dollar based global
monetary system is in the early stages of its end, and that process is
likely to be a protracted and messy one. This is complicated by the fact
that most major western currencies and Japan are now being managed via
central planning with a bias towards debasement as a way to confront the
unsustainable debt loads.

The US Fed and ECB have already begun
expanding their balance sheets in recent weeks in order to, as we would
characterize it, proactively confront the banking and sovereign debt
crisis in the euro zone. We expect that process to continue throughout
2012. In addition, we believe that policy makers will take things up a
couple/few notches as co-incident economic data turns sour during the
first half of the year. For example, US employment data should reverse
its recent modest up tick, which in an election year is sure to stoke
calls for action.

The 2012 US presidential election year is also
of interest, of course. It appears that it is likely to be Romney vs.
President Obama, which to me suggests much of the same economic reality
as the 2008 election. That may sound weird, so let me explain. As I
argued in 2008, both candidates were part of the establishment and would
simply generate the same fiscal and monetary result from different
approaches. I argued Obama would blow out the deficit through social
program spending and have a hard time raising taxes, and that a McCain
administration would do the same thing via tax cuts and military
spending. Ultimately, I expected the result from either to be money
printing from the Fed and big budget deficits.

With the economy
likely to remain weak or even poor for much of the election year, I'd
expect much of the same in 2012. Any fiscal hawkishness is likely to be
filled with election year bluster and rhetoric. When it comes to
governing, I doubt either will look to raise taxes and cut spending
dramatically during a period of elevated unemployment and a weak
economy. Both appear to be part of the Keynsian establishment, which
means that they are likely to continue down the path of what some call
the Keynsian trap. Effectively, their promise for balancing the budget
are forever kicked down the road as the economy is perpetually too weak
to withstand the accompanying pain of those actions.

Just as a
drug addict begins to go through withdrawal if they stop taking the
drug, monetary stimulus and budget deficits are similar. As soon as a
bout of fiscal austerity is implemented or monetary policy tightened,
the economy will likely go through withdrawal. We've seen this in the
summer of 2010 and 2011 as financial markets and the economy weakened as
QE and QEII ended in the US. History suggests that politicians will
continue to make decisions to try and triage the short term pain, which
means more of the drug. Even well intentioned attempts can be crushed
once the reality of austerity and withdrawal hit a society. Social
unrest and political upheaval are typical under those circumstances,
which is why politicians typically end up choosing to go back on the
drug. Ultimately, the addict does so much harm with the drug that an
overdose occurs. In financial markets and economics, this is what we've
seen take place in countries like Iceland and Greece. Currency and bond
markets enter a crisis phase which forces a choice between two bad
options - painful restructuring and contraction, or hyperinflation.

For
2012, we believe it is too early to expect that kind of crisis. In
fact, markets continue to reward what we believe to be the most
destructive long term behavior. Currency and bond markets in countries
with some of the worst long term problems have responded positively to
money printing. One need look no further than interest rates and the
strength of the Japanese yen as an example. The same applies to the US
and UK, where interest rates are near record lows and currencies remain
relatively stable. Ultimately, we expect this to change, but it may take
some time for a crisis phase to be reached. Given the massive amounts
of debt and problems, a crisis could erupt at any time, but our best
guess is that we won't reach that point in 2012 - at least in the US.

Portfolio Positioning

We
remain positioned to benefit from what we see as the major cyclical
trend. Based on our outlook, this means that we are early in a
recession, but that financial markets have already discounted that
development. Markets are in the process of a cyclical recovery, which
will ultimately be followed by the economy doing the same. The long term
structural problems of too much debt remain intact, but those are
likely be a reality for years to come, as policy makers continue to
revert back to the monetary and fiscal drug with any substantial pain.
We believe that the US Fed already flinched with its Twist policy in
late summer, and its coordinated policies with the ECB this fall. They
are likely to continue following the play book Ben Bernanke has laid out
throughout his academic career. Governments from Australia to China to
the US to Brazil are likely to continue to shift towards stimulus as the
1st half of the year unfolds.

Of course, we could be wrong and
another wave of a cyclical downturn could commence, in which case
another version of a 2008-esque crisis would likely unfold. If that does
occur, then our current portfolio positioning will likely be painful
for as long as we maintain it. I'd hope we will begin to see signs in
markets that such a scenario is unfolding and we'd be able to react
accordingly, but obviously that is highly uncertain.

If the scenario I've laid out does play out, or at least relatively close, we expect the following:

1. Global
stock markets will do reasonably well, and very well relative to bond
markets. International markets are likely to outperform the US market -
probably in local currency terms but more likely in US dollar terms.2. Global
bond markets are likely to generate little in the way of returns and
would probably be vulnerable to modest losses. Government intervention
would probably prevent a full out pounding on bonds (unless an all out
crisis emerges.)3. Commodity markets should build a base as they
recover and then possibly ignite as printing presses are cranked up to
higher levels around the world. 4. Countries that are net savers
and more vigilant with their finances would see their currencies
strengthen versus those of the massively indebted countries like the US.
For example, we think people should be more focused on how the US
dollar does versus the northern European currencies or the Singapore
dollar rather than the euro.

While our portfolio positioning was
ok through the first 9 months of 2011, the 4th quarter has been
miserable. I remember feeling much the same way in late 2007, as we had
structured portfolios for a recession and major bear market in stocks.
The last day of the year I felt like an idiot for having done so, and
then a short 3 weeks later felt much better about our positioning. In
all honesty, I think the current backdrop is much more complicated and
challenging than in late 2007, so we are less likely to fight market
conditions if we see things begin to discount a scenario that is
different than what we expect.

Therefore, we continue focus on
companies whose businesses are leveraged to the price of many
commodities, with oil, coal, many agricultural commodiites, gold and
silver being areas we have significant exposure. We also have exposure
to non-US dollar currencies.

Our wildcard for the year is Japan,
as we believe that 2012 may finally be the year in which that country
reaches a tipping point relative to its debt and currency. Ironically,
we'd expect the early stages of a burgeoning crisis in Japan to be
bullish for Japanese stocks, which remain amongst the cheapest in the
world. If the yen finally begins to weaken and the Japanese bond yields
begin to move higher, it would likely result in move into Japanese
stocks, which are dramatically under owned globally and also within
Japan. Ultimately, we expect a crisis in Japan to become so severe as to
make stock positions questionable, but believe that point is out on the
horizon and that there is likely to be a significant opportunity
between now and then. Therefore, we continue to maintain modest exposure
to Japan.

Ultimately, how we perform in 2012 will be the result
of whether or not our outlook is reasonably accurate. If so, then we are
likely to be in pretty good shape. If not or if markets makes sticking
to our guns very difficult for a stretch, as they have in late 2011,
then how we tactically navigate market conditions will be very
important. While we remain confident in our outlook, we are also
prepared to make changes when and if we deem it necessary.

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